Thursday, July 28, 2011

The root causes of global financial instability cannot be wished away or "solved" with modest policy tweaks: they are systemic.

Systemic financial instability is spreading rapidly around the globe. Nobody knows the precise timing, of course, but if we consider the systemic causal forces at work, it seems the future is now: the next few months could see unstable markets gyrate wildly and unpredictably as the latent instability breaks out and plays out into the 2012-2013 timeframe.

Here are a few of the structural causal factors behind the coming global financial instability:

1) What was once considered “impossible” has been normalized to the point that truly unprecedented imbalances are now accepted as "normal." But the normalcy is illusory.

For example, it is now considered “normal” that the Federal government borrows $1.6 trillion every year to prop up the Status Quo, fully 11% of America’s Gross Domestic Product (GDP) and 40% of all Federal expenditures. This stands in stark contrast to the traditional view that deficits in excess of 3% of GDP a year are inherently destabilizing. Now we borrow roughly four times that much (including the off-budget “supplemental appropriations” that run into the hundreds of billions of dollars every year) and the political and financial Elites evince a complacent faith that these extremes are benign and sustainable.

Those who believe unprecedented central bank and State interventions in global markets are not just necessary but positive point to Japan, a nation that thus far is untroubled by debts far in excess of 200% of its GDP. They also point to the rapid growth in developing countries as the engine which will grow the world’s financial pie so everyone’s slice gets bigger every year.

But the fundamental problems in the global economy have not been addressed--they’ve just been papered over with trillions of dollars in printed or borrowed money. Behind the paper-thin façade of “extend and pretend” normalcy, the foundations of the financial Status Quo in China, Japan, the European Union and the U.S. rest on shifting sand. By avoiding structural reform in favor of facsimiles of reform and by “fixing” over-indebtedness with more debt, the political and financial Elites have simply increased the height the world will have to fall to correct the imbalances.

In the forest fire analogy, fixing debt crises by adding more debt is like putting out a small fire: that suppression of a healthy cleansing of the system only guarantees a monstrous fire later.

2) The global economy is now based on a widespread trust that central banks and governments will never let assets fall in value. This insulation from risk is known as moral hazard, as those who are insulated from risk will have an insatiable appetite for risky bets because any gains will be theirs to keep but any losses will be covered by the central bank.

The financial authorities’ success in propping up assets like stocks in the U.S. and real estate in China over the past three years has strengthened this moral hazard into a dangerous quasi-religious faith that central banks and governments have essentially unlimited power to keep asset prices aloft via printing money and easy credit.

3) This isn’t just a failure to reform an opaque and broken financial system: conventional economics has failed. This Grand Failure of Conventional Economics has gone unnoticed, as all those wedded to the Status Quo keep applying “lessons learned” during The Great Depression of the 1930s. They are pursuing the magical-thinking hope that the old rules still apply, even though the fundamentals have changed dramatically.

The Grand Failure of Conventional Economics is more than failed policy: it is a profound blindness to the resource limitations of our planet. Not one of the many strands of conventional economics recognizes the limits on growth in production and consumption as measured by GDP (Gross Domestic Product).

When the planet's human population reached 500 million, there were sufficient resources to enable a doubling to 1 billion. Then 1 billion tripled to 3 billion, which has doubled to 6 billion. Now, as China, India and other nations are industrializing, the 600 million high-consumption "middle class" of the developed economies is expanding four-fold to 2.4 billion.

There simply isn't enough oil and other resources on the planet, in any remotely plausible scenario, for 600 million of China's 1.3 billion people to live on an American scale of consumption, not to mention 600 million of India's 1.2 billion, and another billion avid consumers in other developing economies.

4) Conventional economics is also incapable of grasping the profound consequences of disruptive technologies that are creatively destroying the old foundations of centralized economies and replacing them with decentralized models of much greater efficiency. These new technologies are resistant to controls imposed by concentrations of power such as central banks and governments. Centralization—what I call the “factory” model—reaped enormous gains in the industrialization era; now centralization is increasingly counter-productive, as coordinated monetary manipulations have destabilized the global economy.

Industries that were once mainstays of the economy have been destroyed by irresistibly efficient Internet, communications and digital technologies: long-distance telephony, travel agencies, musical recordings, print media and retailing, to name a few. Next to be disrupted: education, healthcare, finance and government, precisely those industries widely considered immune to creative destruction.

5) These forces are incomprehensible to conventional economics partly because they are triggering simultaneous effects such as deflation and inflation which have been understood as linear and sequential. Disruption of old industries is deflationary to price and employment even as massive government money printing and support of moral hazard is inflationary. As “hot money” flees old industries and seeks higher returns from speculation, asset bubbles expand and pop as capital is misallocated into overcapacity. As money is devalued by these monetary policies, bizarre analogs of money such as derivatives, mortgage-backed securities and tulip bulbs arise and then implode in what I term the speculative supernova model.

6) This dynamic intersection of disruptive new decentralizing technologies, resource depletion and the grand failure of conventional economics is unprecedented in human history; we would have to look back to the era that was transformed by the invention of the printing press, the explosive rise of Renaissance commerce and the discovery of the New World for historical precedents. The difference is the accelerated pace of transformation in our digital era: changes that took 200 years to unfold between 1500 and 1700 will likely be compressed into the next 20 years. The predictability of this process of creative destruction is low; nobody knows what will happen five years hence, much less 20 years hence.

Francis Bacon wrote in 1620 that the printing press "changed the whole face and state of things throughout the world." The same can be said of the Internet and other digital technologies, and the transformation of the global economy is far from complete.

7) From the long view, conventional economics developed in the era of ever-cheaper, ever-more abundant energy and the miraculous "low hanging fruit" productivity gains made possible by cheap energy and centralized mass production. Like a creature born in the morning that has only seen daylight, conventional economics has never experienced night and so it has no conception of darkness.

Thus the current failure of conventional economics is not the failure of individuals or policies--it is a profound conceptual failure. Conventional economics, based on limitless “growth,” globalized financialization, and ever-greater central bank-Central State intervention in markets, is incapable of understanding a world of resource limits and a financial system that is increasingly vulnerable to unpredictable cascades.

Behind the present rose-tinted façade, the only limitless resources are paper money and propaganda. Everything else is limited by real world constraints. An economy that consumes ever-greater quantities of real-world resources such as oil, and harvests renewable resources such as timber and wild fisheries at rates far in excess of their renew rates, will soon encounter shortages and higher prices as those with paper or electronic money bid for the remaining reserves.

8) The markets now depend on massive State and central bank intervention for their veneer of stability. The “ratchet effect” is in full force: every crisis requires ever greater State borrowing and ever larger interventions by central banks. If this vast machinery of intervention were withdrawn, the system’s fundamental instability would be revealed.

This intervention is not limited to monetary policy; official statistics have been gamed to support the Status Quo assertions of a return to prosperity. This legerdemain has two unintended consequences: it discredits the statistics and the government that issues them, and it undermines market correlations that had been valid for decades. Investors and speculators alike are rushing to the lifeboats to find they’re only paper mache stage props.

Gonzalo Lira has graciously invited me to join his Week in Words Webinar #4Thursday, July 28, 9 pm EST (6 pm Pacific) as his guest. As many of you know, Gonzalo is well-informed and articulate, so it should be fun. Register here--it's quick and free.

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